For management to have a good idea of what is taking place with their company, they need to have access to all the information related to the company. Many firms are satisfied looking at information after the fact, when they review the financial statements. Unfortunately that is almost always too late.
I’ve seen it happen in construction too many times as an example. A project is nearing completion, all the reports look like the project will finish under budget when all of the sudden several invoices arrive that the project manager forgot about and the accounting personnel didn’t know about. Suddenly the project that was a winner becomes a big loser and now the company has to find a way to pay for the additional unexpected costs.
In manufacturing, a similar problem would occur when a physical inventory is taken. For example, if goods are received but the company has done a poor job of recognizing goods that have been received but the invoices have been processed into the general ledger. This means the cost for those goods won’t be considered in the inventory balance in the general ledger. Inventory is understated and the company understates the cost of goods sold. When the invoice does arrive the company will be forced to recognize additional expenses. Depending on the size of the invoice this could have a major effect on profitability.
If your company falls into that trap, how do you break free from this negative cycle? You need to close the loop. “The loop” is the ability to monitor what is taking place within the company. For example, if you don’t have the ability to use the software system to identify what is on order for inventory or for a project you have an open system. Your system forces you to guess about the dollars you have committed to purchase, either as part of a project or as part of purchase to replenish inventory, or for other company needs.
Why is this important? Because it affects two key aspects of your business: cash and profitability. Eventually you’ll need to pay for anything you order. With a closed system, management has the ability to forecast the specific cash requirements of the company while having the ability to recognize the costs that will occur. For example, in construction, it is typical for a company to bid or make an estimate related to specific projects. As construction begins, actual costs begin to be recorded against project and can be compared against the original bid. As the project develops and later nears completion, management attempts to estimate the profitability of the job. However, if all purchases are not being recorded and collected within the software system, management is effectively blind to any costs which have not been received into the payable system. This can lead to poor decision making.
Closing the loop means that not only are purchases recorded so that management can tell the cost associated with those orders, but also that visibility of purchase orders are always present. In other words, when orders are received, recognition of the receipt and associated liability is recorded in the general ledger. In a good system, upon receipt, a debit is generated immediately for the goods or services received and a liability, typically called something like, “received not yet invoiced”, is also immediately generated. Then when the invoice is received “received not yet invoiced” is debited and accounts payable is credited. At no time is any liability “invisible” within this system. Management is always aware of all costs associated with the company and surprises are virtually none existent.
Without this process, large expenditures may be incurred by the company without management having any knowledge that the company has incurred this liability. The results can be devastating. Save yourself and member of your company from headache: close the loop so that you can know your costs and your cash requirements.